Fixed Assets to Equity Ratio

by Billie Nordmeyer; Updated September 26, 2017

All businesses require assets to generate revenues. However, the particular assets a business chooses to employ varies greatly from one industry to another, as does the manner in which a firm finances its assets over the long term. In particular, some companies acquire fixed assets through the assumption of long-term debt and others through equity. Leverage ratios are used to illustrate the relative exposure of the shareholders of a business as opposed to its creditors. One such ratio is the fixed-assets-to equity ratio, which measures the ability of a business to rely on both the direct investments in a company and its retained earnings to acquire long-term assets.

Equation

The fixed-assets-to-equity ratio is one type of leverage ratio. It divides a company's fixed assets by its owners’ equity. In this instance, fixed assets refer to a firm's plant, property and equipment, the lifetime of which is three or more years. In turn, shareholder equity includes retained earnings from income generated by the company and paid-in capital.

Use

The financial stability of a company as well as its risk of insolvency can be gauged using equity ratios. The fixed-assets-to-equity ratio in particular measures the relative exposure of shareholders vs. the creditors of a business. Financial leverage increases the business risk of a company in that debt leads to fixed costs that potentially can have a negative effect on profitability in the event that revenues sharply decrease. In addition, the fact that debt and interest takes priority over other business interests can have a negative impact on future operations should the company’s revenue stream dramatically shift for the worse. As a result, the assets-to-equity ratio provides essential information to potential creditors.

Video of the Day

Results

An ideal fixed-assets-to-owners-equity-ratio does not exist. However, a company whose debt is equal to or greater than the value of its assets is not considered to be a good investment. This is true in part due to the debt service obligation that is associated with both short- and long-term debt, which gives rise to the possibility that a firm will be unable to meet its debt obligation in a timely manner. For example, an assets-to-equity ratio that is greater than 100 percent is an indication that a large percentage of a company's productive capacity is financed by long-term loans rather than investments of shareholders and retained earnings. As a rule of thumb, a 65 percent ratio is appropriate for many businesses.

References

"Valuing a business: The Analysis and Appraisal of Closely Held Companies"; Shannon P. Pratt and Alina V. Niculita; 2008

About the Author

Billie Nordmeyer works as a consultant advising small businesses and Fortune 500 companies on performance improvement initiatives, as well as SAP software selection and implementation. During her career, she has published business and technology-based articles and texts. Nordmeyer holds a Bachelor of Science in accounting, a Master of Arts in international management and a Master of Business Administration in finance.

Photo Credits

Hemera Technologies/Photos.com/Getty Images

Cite this ArticleA tool to create a citation to reference this article Cite this Article